“It is one thing that if I had a change to go back, I would be more sensitive to. It is always a balance. Great care has got to be taken not to take a dividend or a distribution from a company that puts that company at risk,” Mitt Romney
Have you ever wondered why there has hardly been any private equity investment in mid-sized to larger accounting firms?
If you haven’t wondered about this, we hope that this perspective will start you thinking about the good, the bad and the ugly of private equity and accounting firms.
From a distance, many private equity firms and lenders have traditionally found mid-sized to larger accounting firms very attractive because:
- Valuations are generally low.
- Balance sheets are void of heavy debt loads.
- Cash flow is usually strong.
- Clients are predominately annuity-based.
And yet, many other private equity firms and lenders consider acquiring mid-sized to larger service businesses, including accounting firms, at the trailing edge of the investment market as these service firms aren’t hugely scalable and therefore generally not in the sweet spot for private equity. Private equity might get singles and doubles from a mid-market transaction, but they won’t hit a home run – and private equity firms are attracted to home runs!
There is, however, a noted example of when, in 2007, private equity purchased about 80% of Philadelphia-based accounting firm, SMART and Associates, for $60 million and by refinancing $60 million of debt and liabilities. In the hands of private equity, which tried combining SMART into publicly traded consulting firm LECG, the old firm went out of business in 2011. What went wrong? Simply, in the 2008 recession, lenders started making demands, “and they could not get out from under it,” according to senior partner Jim Smart. Many SMART and Associates partners and staff hit the pavement and started looking for new positions.
In our opinion, private equity firms and mid-sized and larger accounting firms don’t mix well because accounting firms manage and lead for the longer term and think about the “institution” while private equity thinks short term. There is a caring culture in these accounting firms and the senior partners truly see their employees as their most important assets. This conflict, and the employment displacement it presents to mid-sized to larger accounting firm partners and staff, cause many accounting firms to frown on private equity transactions. Other reasons, including initials cuts in partner compensation and earn-out periods that need to be achieved, are why private equity transactions generally don’t work for accounting firms.
Other negative factors include:
- Private equity firms will want to keep senior accounting firm partners initially employed and busy by making sure clients are properly serviced and transitioned, but after a short period of time, these same partners will be pushed out of the firm.
- Private equity firms will load up on debt that usually amounts to at least three to four times Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).
- Partner perks and discretionary expenses will be brought down to minimum amounts.
- Cash management of receivables and payables will be run very tightly.
In conclusion, there are rumors that a few Top 100 accounting firms are looking at private equity transactions that will be consummated shortly. I do not know if these rumors are true. If true, without knowing the details, I am skeptical that private equity can overcome the historical obstacles that would make accounting firms sign up for these deals. Nevertheless, I wish the accounting firm partners and staff all the best and hope that things will work out.
Dom Esposito leads ESPOSITO CEO2CEO, a boutique advisory firm consulting to leading CPA and other professional services firms on strategy, succession planning and mergers, acquisitions and integration. Esposito was a 2020 IPA Most Recommended Consultant.